Leverage Constraints and Asset Prices: Insights from Mutual Fund Risk Taking

2015 HONORABLE MENTION

Oliver Boguth, Ph.D., and Mikhail Simutin, Ph.D.

Prior theory suggests that time variation in the degree to which leverage constraints bind affects the pricing kernel. We propose a demand-based measure for this leverage constraint tightness by inverting the argument that constrained investors tilt their portfolios to riskier assets. We show that the average market beta of actively managed mutual funds - intermediaries facing leverage restrictions - captures their borrowing demand and thus the tightness of leverage constraints. Consistent with theory, it strongly predicts returns of the betting-against-beta portfolio, and is a priced risk factor in the cross-section of mutual funds and stocks. Funds with low exposure to the factor outperform high-exposure funds by more than 5% annually, and for stocks this difference reaches 7%. Our results show that the tightness of leverage constraints has important implications for asset prices.

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